2008 Social Security Trustees Report

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
April 15, 2008

IN THIS ISSUE:

1. The 2008 Trustees Report Holds No Surprises

2. A Summary Of Social Security’s Woes

3. Medicare Is A Much Bigger Problem

4. Why Won’t Congress Take Action?

5. Don’t Bank On The “Trust Funds”

6. What This Means For Your Retirement Security

Introduction

In what is now an annual ritual of dire predictions, the Social Security Trustees issued their latest report late last month projecting the short-range (10-year) and long-range (75-year) fiscal health of Social Security and Medicare. You may have seen some news articles at the time telling how the “trust funds” are expected to run out of money in the future, possibly leaving beneficiaries in the lurch.

What’s different this time is that the oldest of the Baby Boomers are now eligible for Social Security early retirement, whereas in past articles this was a future event. On October 15, 2007, Kathleen Casey-Kirschling made news by becoming the first Baby Boomer to file for early retirement benefits under Social Security. Since then, thousands have followed suit – the first trickle in what will become a torrent of Social Security beneficiaries.

As you will probably recall, I have written about the funding status of Social Security and Medicare a number of times. Fed chairmen Paul Volker, Alan Greenspan and now Ben Bernanke have all issued warnings about the need to fix the funding of these programs or face negative economic consequences, only to be met with the collective yawns of our representatives in Congress.

Yet, in light of my article last week about the Bear Stearns and mortgage relief bailouts, why is it that these issues get immediate Fed and Congressional attention (and funding), while programs as far reaching as Social Security and Medicare are left unattended? Do they not believe the dire predictions? Is it too complex to get their arms around? Is it just too hot a political potato? Or, most controversially, is there no problem that needs fixing?

In this week’s E-Letter, I’m going to address the Trustees’ most recent report, as well as try to make sense out of why congressional inaction seems to be preferred over a bipartisan attempt to fix the problem. I’ll then tell you what I think the Social Security and Medicare funding issues mean to you personally, and what you should do about it.

Just Another Verse Of The Same Old Song

On March 25, the Social Security Board of Trustees issued its annual report detailing the funding status of the nation’s two largest entitlement programs. It came as no surprise that both programs are projected to eventually run out of money in their “trust funds” (more about that later). I guess the good news is that the dates of the expected shortfalls have not changed.

In 2007, combined Medicare and Social Security benefits cost a total of 7.5% of GDP. Since dealing in percentages can be deceptive, let’s put it in dollars and cents. Based on a total estimated GDP in 2007 of more than $13 trillion, the 7.5% of GDP spent on these two entitlement programs amounted to just under $1 trillion (with a “T”) last year.

It only gets worse from here, according to the Trustees. Projections show that these programs will grow to 12.3% of GDP in 2030, and 13.6% in 2040 as the full brunt of Baby Boomer retirement falls upon the system. Compare these figures with the 18% of GDP that federal tax revenues have averaged over the past 40 years, and you get an idea of what kind of crisis we may be heading for. Unless there is a huge tax hike or a cut in future benefits, little money would be left over in the federal budget for national defense, education, other domestic programs, etc., etc.

On the Social Security side of the coin, the Trustees report that payroll tax revenues will fall below annual expenditures in 2017, the same as last year’s report. At that time, it will begin drawing upon the “trust fund,” which by then is expected to have grown to approximately $2.7 trillion (in present value).

As the Baby Boom generation continues to file for benefits, the Social Security “trust funds” will be slowly depleted, reaching a projected zero balance in 2041. After that, projected tax revenues are expected to cover only approximately 78% of expected benefits.

One bright spot in the report was an improvement in the projected actuarial deficit of the Social Security “trust fund.” The current report projects this shortfall to be 1.70% of taxable payroll, a 0.26% reduction from last year’s estimate. In fact, the Social Security projected actuarial deficit has been in a steady decline for a number of years, but it will likely still require a hike in payroll taxes to cure this deficit.

In fact, the Trustees suggest that an immediate increase in payroll taxes of 14% (from 12.4% to 14.1%), an immediate 12% reduction in benefits, or a combination of the two would cure the actuarial deficit in the long-range outlook. However, I don’t expect any politicians to introduce legislation to take either of these actions anytime soon.

It is also important to note that the Trustees attribute this year’s reduction in the actuarial deficit to a change in the assumptions related to the effect of immigration. This, in turn, shows that any long-term prediction about Social Security is only as good as the assumptions used to develop the numbers. I will discuss the significance of assumptions in more detail later on.

Medicare Is The Bigger Problem

As strange as it may sound, Social Security appears to be quite healthy when compared to its sister program, Medicare. That’s because the future of Medicare not only has to deal with all of the problems facing Social Security (Baby Boom generation, longer life spans, etc.), but also health care costs that are rising at a pace greater than inflation.

In the most recent report, the Trustees stated, “Medicare’s problems come sooner – and are much more severe – than those confronting Social Security.” Yet, even the press seems to concentrate more on Social Security than the bigger problems in Medicare.

The numbers look like this: beginning this year, Medicare’s Hospital Insurance (HI) program is expected to pay out more in benefits than it receives in tax revenues. And even though HI also has a “trust fund,” its reserves are projected to be depleted by 2019, after which time the expenditures will have to be funded from general revenues.

From a GDP standpoint, it’s even worse. Because health care costs are growing so fast, Medicare’s long-range annual costs are expected to jump from 3.2% of GDP in 2007 to 10.8% of GDP in 2082. The trustees also anticipate that Medicare expenditures will outpace even those of Social Security by the year 2028, a mere 20 years from now.

The Trustees also report that the Medicare Supplementary Medical Insurance program that pays for physician services and prescription drug benefits will continue to require an increasing amount of general revenue financing over time. Plus, they anticipate that the required premiums paid by beneficiaries will also continue to grow at a pace “substantially faster than the economy and beneficiary incomes.” What an outlook for those facing retirement.

Something not widely known is that the legislation which enacted the Medicare prescription drug benefit also requires that a warning be issued if the Trustees predict that more than 45% of Medicare’s spending will come from general government revenues within a seven-year window. In fact, you may be surprised to learn that this is the second consecutive year that the Medicare funding warning has been sounded.

So, what does this warning really mean? Not much, actually. The legislation requires the next president to issue a proposal to rein in the costs of Medicare within 15 days after submitting the Fiscal Year 2010 federal budget. Congress then must consider this proposal on an expedited basis. However, there is no requirement that Congress actually pass any legislation to address the situation. President Bush’s legislation required by this law is in the form of H.R. 5480, but it is not expected to receive any serious consideration on Capitol Hill.

Since this law will require the next president to actually issue a proposal to help solve the Medicare funding crisis, you would think that this would be a major issue in the presidential election, wouldn’t you? However, I have yet to hear anything substantial from any of the candidates about this required proposal, much less any actual ideas for curing the problem other than some very broad, general ideas such as “to better coordinate care,” “lower prices for prescription drugs” or “cutting payments in the case of preventable errors.” Just how they would accomplish these feats is anyone’s guess!

Why Won’t Our Elected Leaders Take Action?

Upon the release of the Trustees’ report, Treasury Secretary Henry Paulson called for all sides to come together to find a solution. He was joined by none other than Democratic Representative Charles Rangel of New York who called attention to “the need for Democrats and Republicans to set aside partisanship to ensure the stability of these irreplaceable insurance programs for generations to come.

However, these voices gathered few supporters among their Congressional peers. Instead, it appeared that many of our representatives were either unconcerned or even in denial. Democratic Representative Pete Stark stated, “Reports of Medicare’s death have been greatly exaggerated…This year’s report shows that Medicare remains solvent and sustainable.”

Nancy Pelosi also got into the act, stating “This year's trustees report again makes clear that Social Security will be able to pay its full benefits through 2041.” She then went on to attack the Bush Administration’s fiscal policies, but it was clear that she didn’t think Social Security and Medicare were problems that needed to be addressed.

Did they read the same report that I did? Evidently not!

So, what does merit immediate Congressional attention? I found it interesting that on the same page of the Wall Street Journal discussing the crisis in Social Security and Medicare funding, there was a smaller article that said top Republicans were questioning a Democratic conclusion that Roger Clemens may have lied in his testimony about taking performance-enhancing drugs while playing professional baseball.

So, an investigation as to whether an over-paid participant in a sporting event knowingly took some steroids eclipses the security of governmental programs that benefit tens of millions of Americans. To say that our Congressional representatives have a misguided sense of priorities is the understatement of the century!

Even so, and at the risk of oversimplifying the arguments, I think that the reasons our elected representatives in WashingtonD.C. haven’t taken action before now fall into three categories:

1. Complexity – The task of projecting future costs and benefits for Social Security and Medicare is incredibly complex, requiring the application of mathematical and statistical analysis to predict a range of probable future outcomes. As I stated above, critical to any such analysis are the assumptions used.

As you might imagine, the assumptions surrounding future funding of Social Security and Medicare expenses are many and varied. They include fertility and mortality rates, health care costs projections, projected tax revenues, future inflation, interest rates, productivity growth, the effects of immigration and a host of other factors. Even a relatively small adjustment to any of these assumptions can have a large effect on the probable outcome, especially when making projections for decades into the future.

Adding to the complexity is the fact that not all analysts agree on all of the methods and assumptions used for projecting Social Security and Medicare costs. For example, in last year’s report, the Social Security Trustees estimated the program to become “insolvent” in 2041, while the Congressional Budget Office (CBO) said that this won’t happen until 2046 (all based on a continually growing economy). Thus, it’s not all that hard to find a ‘scientific’ basis for virtually any position a politician may want to take.

2. Problem? What Problem? – As noted above, changes in the assumptions used for projections can produce widely varying results. Thus, there are some politicians who claim that those sounding alarms about Social Security and Medicare are just alarmists, and that there’s going to be no problem with Social Security and Medicare funding in the future, based on their own assumptions.

This kind of thinking is somewhat supported by the fact that the Social Security Trustees actually publish three projected outcomes: the low-cost alternative, high-cost alternative and intermediate assumptions. As you might guess, the low-cost alternative uses very optimistic assumptions about costs and benefits in the future, and comes out with a very favorable future funding projection. In fact, in the low-cost alternative, Social Security never runs out of money.

In the high-cost alternative, just the opposite happens. The assumptions used are the most pessimistic, and result in the Social Security “trust funds” running out of money far before 2041. The intermediate assumptions reflect the Trustees’ best estimate of future experience, and are therefore the ones used in the bulk of their public news releases. However, it’s not hard to see how a politician could take the position that even the intermediate assumptions are too pessimistic, and thus overstate any projected problem.

Thus, the presence of other studies and assumptions that show there will be no future funding problems may give some politicians the “plausible deniability” they need to do nothing. That way, they need make no politically unpopular votes now, and if their assumptions do turn out to be wrong in the future, they’re likely to be retired and collecting their government-guaranteed Congressional pensions. How nice (for them)!

3. Politics As Usual – In his 2007 Senate testimony about Social Security’s future funding problems, Fed Chairman Ben Bernanke briefly mentioned possible solutions to the dilemma – raising the retirement age, increasing payroll taxes or increasing the amount of income subject to payroll taxes (known as the Taxable Wage Base). Another possible solution suggested by some experts involves “needs-testing,” where those with significant assets would either lose part of their benefits, or pay income taxes on a greater portion.

In the Social Security and Medicare discussion, I think it’s safe to assume that: 1) no employer or employee in the US wants to pay more in payroll taxes; 2) no present or future retiree wants to receive less benefits in the future; 3) no one wants to be forced to wait until age 70 to retire; and 4) no one wants to pay more taxes on all or a portion of their benefits. As a result, it’s not very surprising that few politicians want to suggest any of these unpopular solutions to shore up these entitlement programs.

About the only solution the Democrats are likely to support is anything that would shift the burden of paying for a Social Security and Medicare fix onto high-income individuals. I can see the Dems supporting legislation that would make the Social Security portion continue on ALL income, thereby shifting the burden to the “rich.”

However, the inherent problem in this “tax the rich” scenario is that if taxes are paid on all wages, then benefits must accrue on all wages as well. That being the case, the increased taxes may or may not be enough when you consider that increased benefits for the wealthy also have to be funded. Thus, tax increases on high-income individuals may not be effective unless it is coupled with needs-testing.

Put differently, taxing the rich to fund Social Security might only work if you also cut off or limit their benefits. That would likely be political suicide! I doubt the Democrats are ready to go there yet, especially in an election year. However, if either Obama or Hillary wins the White House, this option will definitely be on the table, in my opinion.

The really sad part is that, by waiting to enact effective reforms, our representatives are passing up viable alternatives that are much less draconian than what will be required when their backs are really against the wall in a few years. In his first testimony before the Senate Budget Committee, Fed Chairman Ben Bernanke laid it on the line about Social Security and Medicare when he said, “The right time to start was about 10 years ago.”

Bernanke also predicted that once Baby Boomers start to retire, the federal budget outlook is expected to become considerably worse. He concluded that the most likely result would be: “The US economy could be seriously weakened, with future generations bearing much of the cost.” What else is new? Plus, in a possible effort to pre-answer an objection, Bernanke also said that economic growth alone would not fix the impending fiscal problems.

Since we haven’t yet perfected the technology for a time-machine to go back and implement a solution on Bernanke’s target date of 10 years ago, the best we can hope for is a Congress that will take the bull by the horns and fix the problem NOW, before it gets too much worse. Unfortunately, I see little chance of this happening.

What About The Trust Funds?

Much of the Social Security and Medicare debate is framed around the term “insolvency.” This is assumed to happen when the “trust funds,” that have been built up from the surplus of taxes over expenditures, are exhausted. In the case of Social Security, insolvency is predicted to come in 2041, which is very optimistic in my opinion. For Medicare, projected insolvency is just around the corner in 2018, if not sooner. However, the Social Security and Medicare trust funds are little more than fantasy.

Over the years, surplus funds were collected over and above what it took to fund benefit payments. As a result of Greenspan’s 1983 recommendation, tax rates were raised so that an even greater amount would go into these trust funds in an effort to extend the solvency of the program. During that time, however, Congress spent the money in the trust funds and replaced it with special Treasury securities that represent nothing more than IOUs. A 2002 Congressional Budget Office Policy Brief probably best described this arrangement:

“Trust fund holdings, as internal liabilities between government accounts, are not assets of the government. Nor do they represent money owed to program recipients individually; payments to Social Security recipients and beneficiaries of other social insurance programs are based on a variety of rules set by law unrelated to trust fund holdings. A federal trust fund is basically an accounting device that measures the difference between the income designated for a specific program and the expenditures made to its beneficiaries. The accumulated difference, or balance, often represents a reserve of future ‘spending authority’ for the program, but it is not a reserve of money for making payments.” [Emphasis added]

“In the future, when receipts for such programs as Social Security fall below their expenditures, the legal authority to pay benefits will exist as long as their trust funds have balances, but the government will have to generate cash to pay benefits either by running a surplus in the rest of the budget--which would probably require cutting other spending or raising taxes--or by borrowing from the public.”

Note the last part of the CBO’s statement. If we’re not running budget surpluses by the time entitlement expenditures are expected to overtake tax revenues (fat chance!), then the government will have to borrow from the public. That means fund the “spending authority” with Treasury Bonds. To me, that sounds a little like paying your VISA bill with your MasterCard. And don’t forget, someone will have to buy all those T-bonds!

What All This Means For You & Me

While I firmly believe that both Social Security and Medicare will continue to be available in some form well into the future, I also think that changes will be required to keep spending on these entitlement programs at levels that will not tank the economy. Therefore, the level of benefits you may receive in the future may not be what has been promised.

As a result, I always counsel my clients to plan for retirement as if they were not even covered by Social Security. That way, if you are successful in your investment plan, any Social Security benefit that may be paid will be gravy. The following simple rules can help you to build a retirement nest egg so that there is some “gold” in your golden years:

1. The first and most obvious rule is that you should elect to participate in any tax-deferred/retirement programs offered to you through your employer. Recent law changes have made it possible for even the smallest of employers to sponsor 401(k)-type retirement plans, even if the employer cannot afford to contribute to the plan or match employee contributions. If your employer does not sponsor a plan, ask him or her to check out the SIMPLE IRA or a SEP IRA, or consider opening up your own IRA.

2. You should also contribute the maximum allowed every year to your own traditional or Roth IRA, even if you are covered by an employer’s plan. If you are not covered by an employer plan, you should definitely be contributing to an IRA. For more information about Roth and traditional IRA contribution limitations, see IRS Publication 590 available on the IRS website (www.irs.gov).

3. Once you decide to take advantage of all of the retirement savings vehicles available to you, you also need to maximize your contributions to these plans to the extent possible. If you can’t contribute the maximum percentages, do what you can and try to increase your percentage each year.

4. Another rule of successful retirement planning is to use time to your advantage. In a nutshell, this means to pile as much money up as quickly as you can when you are young. This gives the magic of compound interest the maximum number of years to work to your advantage. If you procrastinate about participating or maximizing your contributions while young, you lose valuable years for compounding.

5. When switching jobs, resist the temptation to spend retirement distributions. Take advantage of direct rollover opportunities to maintain the tax-deferred status of your accrued retirement benefits. I have clients who have multiple rollover IRAs, one from each former job. However, these IRAs continue to grow tax-deferred, and when combined, can amount to quite a nice retirement fund for these clients.

6. If you must borrow from your retirement funds, plan how and when you will repay the loan as soon as possible. I am not one to say that you should never borrow from your retirement funds; emergencies can happen. However, such loans should only be made as a last resort, and the money should be repaid ASAP.

7. Make wise investment decisions. Today, there are many investment options that are available to retirement plans, ranging from low-risk CDs to very high-risk products that can potentially lose all the money you put in them. If you have read my E-Letters for long, you know that I recommend that most people use professional Investment Advisors to help make their investment decisions.

While the availability of professionally managed programs will vary with the type of plan that you have, it’s important that you take advantage of whatever resources are available to you to maximize your investment diversification and potential returns. Most large companies with retirement plans have a Human Resources Department that should provide educational materials about investing and may be able to recommend qualified professionals to help make retirement plan investment decisions. Check with your Human Resources or Personnel Department staff to see if such resources are available.

If no such resources are available to you, or you have an IRA or other individual plan, feel free to call one of our Investment Consultants at (800) 348-3601 or send us an e-mail at info@halbertwealth.com, and we’ll be happy to help.

Conclusion – The Future Is Now

As I noted in the beginning, one big difference between this year’s Trustee report and those of previous years is that we are now seeing the first wave of Baby Boomers starting to file for early retirement. Thus, the future is now, and from here on out we’ll continue to see this demographic tidal wave have its effect upon our two largest entitlement programs.

While the gutless politicians in Washington choose to ignore it, I believe there really is a looming crisis in relation to Social Security and Medicare solvency. I think those that say otherwise are just a continuation of the “let a future Congress worry about it” political attitude that created the problem in the first place. I believe it will be a crisis because we have postponed doing anything meaningful to fund future entitlement benefits.

As a result, virtually all of the possible solutions – raising the retirement age, raising payroll taxes, needs-testing, or cutting benefits - are viewed as draconian, which is why we’re not likely to see a change anytime soon, especially with the Democrats in power, AND especially in an election year.

Fed Chairman Bernanke warned us last year that we are already too late in taking action to shore up these programs. Unfortunately, I believe he is correct.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

2008 Social Security Trustees Report Continues to Show the Urgent Need for Reform
http://www.heritage.org/Research/SocialSecurity/wm1868.cfm

An Alternate View: Social Security Is More Secure Than Many Think
http://www.wthr.com/Global/Story.asp?S=8143087

Social Security Looms for the Next President
http://money.cnn.com/2008/03/25/news/economy/socsec_candidates_trustees/?postversion=2008032610